Last week, the Fed once again announced that it will refrain from tapering its bond-buying program until it sees more evidence that the economy is improving.
While this statement was less of a surprise than the Committee's September announcement, as usual it will incite a lot of speculation about the expected timing of a taper. But whether you believe it will occur in two months or twelve, the bottom line is that quantitative easing will eventually come to an end and, subsequently, interest rates will rise.
Investors widely acknowledge this fact, which is why for the past year we've seen a huge shift in bond ETF flows from intermediate and long duration funds to short duration funds (link to latest flows post). Longer duration bonds generally offer more yield, but they're also subject to greater price declines when interest rates rise. Because of this, investors that fear a rate rise often shorten the duration of their bond portfolios, believing that the yield they give up will be more than compensated for by avoiding a price loss with longer duration bonds.
ETFs are a great way to execute this strategy. Because of the wide variety of bond ETFs out there, it's easy to customize your short duration bond exposure using just one or two funds.
So how do you choose the right short duration bond ETF for your portfolio? It all depends on your investment goals:
|If your goal is . . .||Try a . . .||Potential iShares solutions|
|Diversification||Multi-sector ETF to help lower interest rate risk but maintain exposure to a range of asset classes.|
|Low risk||U.S. Treasury ETF to seek both reduced interest rate risk and the safety of Treasury bonds.||iShares Short Treasury ETF (NYSEARCA:SHV) iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY)|
|Credit risk||Credit ETF to help reduce interest rate risk but still have potential for yield by investing in corporate bonds that carry credit risk.||iShares Floating Rate Note ETF (NYSEARCA:FLOT) iShares 1-3 Year Credit Bond ETF (NYSEARCA:CSJ) iShares 0-5 Year Investment Grade Corporate Bond ETF (NYSEARCA:SLQD) iShares 0-5 Year High Yield Bond ETF (NYSEARCA:SHYG)|
|Declining maturity over time||Term maturity ETF if you have a specific time horizon for your investment, or you want a fund that matures on a specified date and has a final distribution like individual bonds.||iSharesBonds 2016 Corporate Term ETF (NYSEARCA:IBDA) iSharesBonds 2016 ex-Financials Term ETF (NYSEARCA:IBCB)|
And if you're wondering how these exposures compare when it comes to yield (measured by average yield to maturity) and duration, check out the chart below*:
You can't control when interest rates will rise, but you can prepare your portfolio for that eventuality. Luckily, ETFs make that task a bit easier by allowing investors to employ strategies like reducing portfolio duration in an efficient and customized way.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.